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Chapter 6 Inventories Copyright © Cengage Learning. All rights reserved.

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1 Chapter 6 Inventories Copyright © Cengage Learning. All rights reserved.

2 Managing Inventories Objective 1
Explain the management decisions related to inventory accounting, evaluation of inventory level, and the effects of inventory misstatements on income measurement. Copyright © Cengage Learning. All rights reserved.

3 Inventory Considered a current asset because it will normally be sold within a year’s time or within a company’s operating cycle. Merchandising Entities Merchandise Inventory consists of all goods owned and held for sale in the regular course of business Manufacturing Entities Maintain other types of inventories Raw Materials Work in Process Finished Goods Copyright © Cengage Learning. All rights reserved.

4 Components of Work in Process and Finished Goods Inventory
Cost of the raw materials that go into the product Cost of the labor used to convert the raw materials to finished goods Overhead costs that support the production process (indirect materials like paint, glue; indirect labor such as salaries of supervisors; factory rent; depreciation of plant assets) Copyright © Cengage Learning. All rights reserved.

5 Inventory Decisions A primary objective of accounting is to determine income properly by matching costs of the period to revenues. Inventory processing systems Costing methods Valuation methods Result in different amounts of reported net income, taxes paid, and cash flows Copyright © Cengage Learning. All rights reserved.

6 Inventory Turnover Measurement of the number of times a company’s average inventory is sold during an accounting period. Cost of Goods Sold Average Inventory Inventory Turnover = Toyota’s Inventory Turnover = $155,495 m ($15,281 m + $13,799 m) ÷ 2 = times Copyright © Cengage Learning. All rights reserved.

7 Days’ Inventory On Hand
Indicates the average number of days required to sell the inventory on hand. Number of Days in a Year Inventory Turnover Days’ Inventory on Hand = Toyota’s Days’ Inventory on Hand = 365 days 10.7 times = days Copyright © Cengage Learning. All rights reserved.

8 Inventory Turnover for Selected Industries
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9 Supply Chain Management
Computerized system that a company uses to order and track inventory goods A just-in-time operating environment helps reduce inventory levels by coordinating orders and shipments of products so that they arrive “just in time” for customer orders Using these procedures and processes means that less money is tied up with carrying inventory Copyright © Cengage Learning. All rights reserved.

10 Effects of Inventory Misstatements on Income Measurement
If inventory is overstated… Cost of goods sold is understated Income before income taxes is overstated If inventory is understated… Cost of goods sold is understated Income before income taxes is understated Copyright © Cengage Learning. All rights reserved.

11 Inventory Errors: Examples
Column 1 Inventory Correctly Stated Net Sales $100,000 Beg. Inv. $12,000 Net purchases 58,000 Cost of goods available for sale $70,000 End. Inv. 10,000 Cost of Goods Sold $ 60,000 Gross margin $ 40,000 Operating expenses 32,000 Income before income taxes $ 8,000 Column 2 Inventory Overstated Column 3 Inventory Understated $100,000 $12,000 58,000 $70,000 16,000 4,000 $54,000 $ 66,000 46,000 $ 34,000 32,000 $14,000 $ 2,000 Copyright © Houghton Mifflin Company. All rights reserved. Copyright © Cengage Learning. All rights reserved.

12 Inventory Cost and Valuation
Objective 2 Define inventory cost, contrast goods flow and cost flow, and explain the lower-of-cost-or-market (LCM) rule. Copyright © Cengage Learning. All rights reserved.

13 Inventory Cost Includes: Invoice price less purchases discounts
Freight-in, including insurance in transit Applicable taxes and tariffs Cost for ordering, receiving, and storing In principle, should be included in inventory cost In practice, are usually considered expenses of the period (too difficult to allocate to specific inventory items) Copyright © Cengage Learning. All rights reserved.

14 Goods Flow and Cost Flow
Actual physical movement of goods in the operation of the company Cost Flow Association of costs with their assumed flow in the operation of the company Not always the same Copyright © Cengage Learning. All rights reserved.

15 Lower-of-Cost-or-Market Rule
Cost is usually the most appropriate basis for the valuation of inventory. Sometimes inventory should be shown on financial statements at less than its cost. Physical deterioration, obsolescence, or decline in price level may cause a loss to occur. The lower-of-cost-or-market (LCM) rule requires that when the replacement cost of inventory falls below historical cost, based on one of the conventional inventory costing methods, the inventory is written down to the lower value and a loss is recorded. Copyright © Cengage Learning. All rights reserved.

16 Disclosure of Inventory Methods
Cisco Annual Report Inventories: Inventories are stated at the lower of cost or market. Cost is computed…on a first-in, first-out basis. The company provides allowances on excess and obsolete inventories. Users should pay attention to the inventory disclosures in the notes to financial statements. Copyright © Cengage Learning. All rights reserved.

17 Inventory Cost Under the Periodic Inventory System
Objective 3 Calculate inventory cost under the periodic inventory system using various costing methods. Copyright © Cengage Learning. All rights reserved.

18 Inventory Costing Methods
Inventory cost is determined using one of the following generally accepted methods, each based on a different assumption of cost flow: Specific identification method Average-cost method First-in, first-out method Last-in, last-out method Copyright © Cengage Learning. All rights reserved.

19 Specific Identification Method
Identifies the cost of each item in ending inventory as coming from a specific purchase May be used for high-priced articles Disadvantages Difficulty and impracticality of keeping track of the purchase and sale of individual items When items are identical but purchased at different costs, deciding which items were sold becomes arbitrary (company can raise or lower income by choosing the lower- or higher-cost items) Copyright © Cengage Learning. All rights reserved.

20 Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases Inventory Data April 1 Inventory 160 units @ $10.00 $ 1,600 April 6 Purchase 440 units @ $12.50 5,500 April 25 400 units @ $14.00 5,600 Goods available for sale 1,000 units $12,700 Sales 560 units On hand April 30 Specific Identification Method Cost of Goods Sold = $12,700 – 5,460 = $7,240 $ 1,000 100 $10.00 2,500 200 $12.50 1,960 140 $14.00 Ending Inventory $5,460 440 units Copyright © Cengage Learning. All rights reserved.

21 Average-Cost Method Computes the average cost of all goods available for sale during the period to determine the value of ending inventory Tends to level out the effects of cost increases and decreases Is criticized by some who believe that recent costs are more relevant for income measurement and decision making Copyright © Cengage Learning. All rights reserved.

22 Ending Inventory = 440 @ $12.70 = $5,588
Average-Cost Method Inventory Data April 1 Inventory 160 units @ $10.00 $ 1,600 April 6 Purchase 440 units @ $12.50 5,500 April 25 400 units @ $14.00 5,600 Goods available for sale 1,000 units $12,700 Sales 560 units On hand April 30 Inventory is priced at the average cost of the goods available for sale during the period Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost $12,700 ÷ 1,000 units = $12.70 Ending Inventory = $12.70 = $5,588 $7,112 Cost of goods sold 5,588 Less April 30 inventory $12,700 Cost of goods avail for sale Copyright © Cengage Learning. All rights reserved.

23 First-In, First-Out (FIFO) Method
Based on the assumption that the costs of the first items acquired should be assigned to the first items sold. The cost of ending inventory reflects the cost of merchandise from the most recent purchases. The costs assigned to cost of goods sold are from the earliest purchases. Copyright © Cengage Learning. All rights reserved.

24 Effect of FIFO Method Values the ending inventory at the most recent costs and include earlier costs in cost of goods sold. During periods of consistently rising prices FIFO yields the highest possible amount of net income Cost of goods sold will show earliest, lower costs incurred During periods of consistently falling prices FIFO yields the lowest possible amount of net income Cost of goods sold will show most recent, higher costs incurred A major criticism of FIFO is that it magnifies the effects of the business cycle on income. Copyright © Cengage Learning. All rights reserved.

25 First-In, First-Out Method
Inventory Data April 1 Inventory 160 units @ $10.00 $ 1,600 April 6 Purchase 440 units @ $12.50 5,500 April 25 400 units @ $14.00 5,600 Goods available for sale 1,000 units $12,700 Sales 560 units On hand April 30 Assumes that the first units purchased will be the first units sold; Ending inventory is priced using the most recent purchases First-In, First-Out Method (Value Remaining Inventory) 400 $14.00 from purchase of April 25 $5,600 40 $12.50 from purchase of April 440 units at a cost of $6,100 $6,600 Cost of goods sold 6,100 Less April 30 inventory $12,700 Cost of goods avail for sale Copyright © Cengage Learning. All rights reserved.

26 Last-In, First-Out (LIFO) Method
Based on the assumption that the costs of the last items acquired should be assigned to the first items sold. The cost of ending inventory reflects the cost of merchandise purchased earliest. The costs assigned to cost of goods sold are from the most recent purchases. Copyright © Cengage Learning. All rights reserved.

27 Effect of LIFO Method Values the ending inventory at the earlier costs and include most recent costs in cost of goods sold. This assumption does not agree with the actual physical movement of goods in most businesses. Current value of inventory may be unrealistic. Balance sheet measures (such as working capital and current ratio) may be distorted and must be interpreted carefully. Prohibited by IFRS Copyright © Cengage Learning. All rights reserved.

28 Effect of LIFO Method (cont’d)
Strong logical argument for LIFO Fairest determination of income occurs if the current costs of merchandise are matched against current sales prices. Smoothes out fluctuations in the business cycle As prices move upward or downward, cost of goods sold will show costs closer to the price level at the time the goods were sold. Copyright © Cengage Learning. All rights reserved.

29 Last-In, First-Out Method
Inventory Data April 1 Inventory 160 units @ $10.00 $ 1,600 April 6 Purchase 440 units @ $12.50 5,500 April 25 400 units @ $14.00 5,600 Goods available for sale 1,000 units $12,700 Sales 560 units On hand April 30 Ending inventory is priced using the earliest purchases Last-In, First-Out Method 160 $10.00 from April 1 inventory $ 1,600 280 $12.50 from purchase of April ,500 440 units at a cost of $5,100 $7,600 Cost of goods sold 5,100 Less April 30 inventory $12,700 Cost of goods avail for sale Copyright © Cengage Learning. All rights reserved.

30 Impacts of Inventory Cost Flow Assumptions
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31 Stop & Review Do the FIFO and LIFO inventory methods result in different quantities of ending inventory? A. The quantities of ending inventory are the same under FIFO and LIFO. These methods affect the valuation of the inventory, not the quantities Copyright © Cengage Learning. All rights reserved.

32 Impact of Inventory Decisions
Objective 4 Explain the effects of inventory costing methods on income determination and income taxes. Copyright © Cengage Learning. All rights reserved.

33 April Example: Period of Rising Inventory Purchase Prices
Impact on Gross Margin April Example: Period of Rising Inventory Purchase Prices Highest gross margin Lowest gross margin In times of declining prices: FIFO results in lowest gross margin, LIFO results in highest gross margin. Copyright © Cengage Learning. All rights reserved.

34 Usage of Costing Methods
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35 LIFO Method Best suited for the income statement because it matches revenues and cost of goods sold. Not the best measure of the current balance sheet value of inventory, particularly during a prolonged period of price increases and decreases. Copyright © Cengage Learning. All rights reserved.

36 FIFO Method Best suited to the balance sheet because the ending inventory is closest to current values. Gives a more realistic view of the current financial assets of a business. Does not provide as good a matching of current costs and revenues for income statement purposes. Copyright © Cengage Learning. All rights reserved.

37 Inventory and Income Taxes
Method chosen must be used consistently from year to year (may change with IRS approval if there is a good reason, exception—a change from LIFO). If a company uses LIFO for tax purposes, the IRS requires the same method for financial reporting. IRS will not allow lower-of-cost-or-market inventory valuation if LIFO is used. Copyright © Cengage Learning. All rights reserved.

38 Effects on Income Taxes
In periods of rising prices… FIFO and Average Cost LIFO Profit may be overstated Inventory may be valued at a cost far below current prices Business will pay excess income taxes LIFO liquidation may occur; inventory quantity at year end falls below the beginning-of-year level Business will pay higher income taxes Copyright © Cengage Learning. All rights reserved.

39 Stop & Review Which inventory costing method assumes results in the highest gross margin in times of rising inventory costs? A. First-in, first-out method (FIFO) Copyright © Cengage Learning. All rights reserved.

40 Chapter Review Explain the management decisions related to inventory accounting, evaluation of inventory level, and the effects of inventory misstatements on income measurement. Define inventory cost, contrast goods flow and cost flow, and explain the lower-of-cost-or-market (LCM) rule. Calculate inventory cost under the periodic inventory system using various costing methods. Explain the effects of inventory costing methods on income, inventory balance, and income taxes. Copyright © Cengage Learning. All rights reserved.


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